There seems to be increasing interest in risk controlled products such as volatility target indices and derivatives products on these underlyings. From a risk management perspective what are the advantages of these products?

1 Answer
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Typically these options are sold to portfolio managers to help smooth out their returns in times of trouble. A call (or even long position) on such an index will give a little PL in precisely the sort of markets that long-biased portfolio managers often lose money in, since high volatility is empirically correlated with negative returns. That keeps risk down, and PL smooth.

Most of these customers could be trading variance swaps or options on VIX instead. They could even use stock futures index puts to get insurance they want. These options are "more precisely targeted" at what they think they want to hedge, and require less frequent attention than VIX positions (though not necessarily less than a varswap).

In addition, a hedge fund manager who says to his investors that he hedges risk with varswaps or VIX invites questions about his competence with those products, whereas one who buys protection marketed by an investment bank is presumed -- by the typical HF investor -- to have received proper guidance from his bankers on the investment.

In practice, I am sure that the options are terribly expensive trades for the customers, many of whom would be better off with trades in more liquid and transparent securities such as varswaps or (if they can spare the time) stock futures option/VIX positions. It's cheaper, and I attribute scant value to the advice of the bankers.

+1 for "I attribute scant value to the advice of the bankers."
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Tal FishmanAug 15 '11 at 16:08

Excellent answer. Perfectly explains why some would do this, even if they are "paying through the nose" so to speak. EDIT: That is a very old expression, nothing to do with any illegal activities. Just occurred to me!
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Ellie KesselmanOct 21 '11 at 1:24